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In this article Neil Maines and Chris Beattie outline how the idiosyncratic structure of the UK pensions industry drove the recent challenges and how the implications may present opportunities for Australian investors.
Over the past fortnight there has been significant coverage in the financial market press in relation to the volatility in the UK government bond market and the resulting challenges faced by UK Defined Benefit (DB) pension schemes. Consultants Chris Beattie and Neil Maines both spent a number of years advising these schemes prior to joining JANA. In this article they outline how the idiosyncratic structure of the UK pensions industry and recent UK government policy drove the recent challenges and how the implications may present opportunities for Australian investors.
The transition from final salary-based DB schemes to a Defined Contribution (DC) system has been much slower in the UK than Australia. UK DB schemes represent a significant institutional investor holding c.£1.5tn in assets. Similar to Australian DB funds, funds in the UK must undertake an actuarial valuation where liabilities are projected and discounted to determine a present value. Discount rates used to determine the present value are based on inflation-linked UK government bond yields and therefore UK real yields present the biggest risk for the majority of DB schemes from a funding perspective. This risk gets the attention of the employer that sponsors the scheme given the deficit is a component of the sponsor balance sheet and the employer will typically be required to make contributions to help reduce the deficit.
Unlike Australian equivalents, DB funds in the UK typically have funding levels below 100%. This means that they have two primary challenges, firstly to close the funding deficit but also to hedge exposure to UK real yields to protect against an adverse change in present value of the liabilities.
Liability Driven Investing (LDI) is a strategy used to help break the aforementioned trade-off and allow both the hedging of liabilities and maintenance of sufficient exposure to growth assets to close the deficit. In the example below, pre-LDI, an investment in unleveraged UK government bonds would hedge only 25% of changes in the liability present value, leaving an undesirable unhedged exposure to real UK government bond yields, in part due to the funded position of the schemes. LDI strategies use leverage to increase exposure to these bonds (either via repo trades1 or using swaps). This financial engineering allowed a significant proportion of liabilities to be hedged whilst freeing up enough capital to invest in growth assets to close the deficit. In the example below, using leverage allows a much greater proportion of changes in the liability present value to be hedged.
LDI strategies had paid off handsomely since the global financial crisis for schemes that had high levels of liability hedging as bond yields around the world trended lower and lower. Lower bond yields had (until recently) driven increases in liability present values, with LDI assets delivering broadly similar returns to hedge this risk.
Over the past c.12 months, the UK has experienced similar inflation challenges to the rest of the world. The replacement of former Prime Minister Boris Johnson with Liz Truss also led to the appointment of a new Chancellor, Kwasi Kwarteng. In what has been described as a ‘mini budget’, Chancellor Kwarteng announced an aggressive set of unfunded tax cuts on 23 September. Financial markets immediately became concerned about the impact of this policy shift on inflation. Investors envisaged this policy would require more aggressive interest rate hikes in the future. As the below chart detailing the 10 year real government bond yield illustrates, a decade of reductions in interest rates were reversed within the space of a week.
The 10-year UK real yield increased from c.-1.0% on 20 September to c.+1.2% in the morning of the 28 September (the above chart underplays the volatility as it only shows end of week yields). Continuing the example above, and to keep the numbers simple, a 2% increase to real yields would:
The problem is the LDI portfolio is now worth $10m ($25m minus $15m) but is hedging $60m of liabilities, i.e. leverage has doubled from 3x to 6x. LDI fund managers required the UK DB funds to post collateral in the form of cash or government bonds over a short timeframe in order to reduce the leverage in LDI portfolios. This required DB funds to liquidate assets in order to meet the LDI manager capital calls or risk having their liability hedging exposure reduced at a time of extreme bond market volatility. A report from the Bank of England (BoE)2 stated that several LDI managers indicated their belief that DB funds would not be able to provide sufficient capital in time (e.g. because this was often invested with different fund managers in vehicles with longer redemption timescales). The next step was for the LDI funds to sell their government bond holdings, but negligible liquidity meant this exacerbated the problem and put further upward pressure on yields.
On 28 September the BoE deemed it necessary to intervene and announced the ability to purchase £5bn per day of nominal UK sovereign debt for a fortnight to combat a ‘material risk’ to UK financial market stability. This resulted in an almost immediate and significant reduction in bond yields which thus far has eased the pressure on funds and provided a source of liquidity for LDI fund managers that want to reduce leverage by selling bonds.
Prior to recent events, LDI managers required UK DB schemes to post enough collateral to cover a 1-1.5% increase in government bond yields in order to manage leverage within target ranges. Our understanding is that this is now a 2% minimum with some LDI managers requiring enough collateral to cover an even greater increase in yields. This is a material development and further increases the liquidity pressures on DB schemes.
Some DB schemes have been forced to sell, and are continuing to sell, liquid and semi liquid assets in order to meet these more stringent requirements imposed by LDI managers. In some cases, DB schemes have had to sell at a discount or incur above average transaction spread costs on pooled funds given the time constraints. Asset classes that have been targeted for liquidation include listed equities, absolute return bond strategies (ARBS), multi asset credit strategies (MAC) and forms of structured credit, e.g. mortgage backed securities. Anecdotally, we are aware of some DB schemes asking managers to sell units and cancel future undrawn commitments into illiquid funds. In some cases, managers have been unable to do this.
This forced selling may present attractive buying opportunities for Australian investors over the short to medium term.
Once the dust has settled on this initial wave of forced selling, we expect the investment strategies of UK DB schemes to be broadly made up of two-thirds LDI portfolio and one-third growth assets, including more illiquid assets such as unlisted infrastructure, unlisted property, private credit and private equity. A longer term trend we expect to play out is UK DB schemes looking to sell their illiquid assets for two different reasons, either to generate higher expected investment returns or transfer their liability risk to an insurer (often referred to as buy out). We discuss each driver below.
Given the forced selling of listed equities to meet LDI capital calls and lower leverages available from LDI strategies, the expected long term return of many DB scheme investment strategies will have reduced. DB schemes that still have a funding deficit following the increase in yields will be required to generate a return above UK government bonds in order to reduce the deficit over time. Some schemes will therefore need to sell down some of their unlisted asset exposure and start buying high return seeking assets such as listed equities again.
On the other hand, some DB schemes will now be in surplus following the increase in real yields and reduction in liabilities. Despite the recent challenges, many DB schemes now have a stronger funding position than they did 12 months ago given the majority of schemes have some proportion of their liabilities unhedged. For many schemes, buying out the liabilities with an insurer is the end game and they will now be much closer to being able to do this. These DB schemes will likely need to sell their unlisted assets in order to fund the buy out as many insurers are unlikely to take these assets as part of any in specie transfer.
Both of the scenarios outlined above may present buying opportunities in unlisted markets. JANA currently has a number of researchers on the ground in the UK having conversations with investment managers in relation to potential investment opportunities. This topic will likely continue to evolve over the coming weeks, for example, the BoE were forced to extend the intervention to the inflation-linked UK government bond market on 11 October as yields continued to rise (the 30 year UK index-linked gilt fell in value by 16% within a day). The BoE has since stated that the purchases will cease on 14 October. We will keep clients updated with developments and any attractive opportunities that we become aware of.
1 A repo or repurchase agreement is a form of collateralised borrowing used in the government bond market. An LDI manager sells government bonds, agrees to buy them back for a slightly higher price at a set date and uses the borrowed funds to purchase more government bonds, thereby achieving leverage.
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